Debt-to-GDP and the Companion Graph

 

The reduction in inflation that occurred in the early 1980s, when the Federal Reserve was headed by Paul Volcker, is arguably the most widely discussed and visible macroeconomic event of the last 50 years of U.S. history.

- Goodfriend and King, 2005

But that disinflation is ignored in discussions of the Debt-to-GDP ratio.

- Arthurian

Download the PDF

The first graph here shows nonfinancial debt relative to Gross Domestic Product:

Graph #1: TCMDODNS / GDPA at FRED

Economists dwell on the remarkable stability of this ratio before 1981, and focus on the sudden sharp increase after 1981:

• "The combined indebtedness of both government and private-sector borrowers, which earlier had shown considerable stability in relation to the economy's overall growth, and especially so since World War II, has since 1980 jumped far out of proportion with nonfinancial economic activity." (B. Friedman 1986, p.1)
  
  
• "One clear limitation of our dataset is that it starts in 1980. It is sufficient, however, to look back at the history of the United States (for which long back data are easily available) to understand how extraordinary the developments over the last 30 years have been. As Graph 2 [here, Graph #1] shows, the US non-financial debt-to-GDP ratio was steady at around 150% [here, 140% and until the early 1980s] from the early 1950s until the mid-1980s." (Cecchetti et al 2011, p.6)
  
  
• "When did financialization start? While there is much literature on the increasing dominance of finance in the United States after 1970, ... most analysts emphasize the neoliberal period beginning in the 1980s." (Fasianos et al 2016, p.2)
  

What caused the sharp increase in the Debt-to-GDP ratio in the 1980s? Financialization was not the cause. Financialization did not emerge fully formed from the void in 1981. The sudden increase in the ratio happened when Paul Volcker's anti-inflation policy started working. The next graph shows growth rates for debt and GDP, separately, using the same source data as the first graph:

Graph #2: Companion Graph Showing the FRED data TCMDODNS and GDPA

Growth is shown for moving 20-year periods. The first value of each line, plotted at 1966, indicates the rate of growth of the 1946-1966 period. The second value indicates the 1947-1967 period, etc.

GDP and nonfinancial debt run close from 1966 to 1981 -- essentially from 1946 to 1981 -- and incredibly close from 1974 to 1981. This confirms the standard evaluation of the standard Debt-to-GDP graph: stability before the 1980s.

But the lines separate after 1981, just as the Debt-to-GDP ratio rises. This is not because of any significant change in the path of debt. Graph #2 shows little change in the path of debt. Nor do the lines separate because of any significant change in the growth of Real GDP:

Graph #3: Showing FRED data TCMDODNS, GDPA, and GDPCA

The separation after 1981 can only have been due to a change in the path of the price level, as the price level is the only difference between real and nominal GDP. I am therefore forced to conclude that the sudden, sharp increase in Debt-to-GDP after 1981, visible on the first graph, was a direct consequence of the Volcker disinflation.

The price level caused debt and GDP to run together until Volcker, and then the price level caused debt and GDP to diverge.

The sudden increase in the Debt-to-GDP ratio in the 1980s was the result of anti-inflation policy. It was not the result of financialization emerging suddenly, like an evil butterfly escaping an innocuous cocoon.

The Debt-to-GDP graph shows the path of debt, but shows it relative to GDP. The companion graph shows the path of debt and the path of GDP, and shows them separately so that they may be evaluated and compared.

The essential point is that the growth of debt was rapid, persistent, and (as the vertical axis values show) accelerating without hesitation from the early days until 1986. There was no sharp change in debt growth until after the rise in Debt-to-GDP -- and the change, when it came, was decrease. The problem with debt is not the increase since 1981, but the increase since the end of the second World War.

The logic that says rapid growth of debt is okay until debt becomes a problem is the logic that creates the problem.

 

It was inflation that kept the ratio low. It was the Great Inflation that kept the Debt-to-GDP ratio low from the mid-60s to the Volcker disinflation. Without the Great Inflation, the ratio would have looked more like this:

Graph #4: Inflation messes with the debt-to-GDP ratio

As Investopedia says, "the beginnings of financialization in the United States can be traced as far back as the 1950s".

Data

Debt: quarterly by default, set to annual frequency and end-of-period aggregation
Domestic Nonfinancial Sectors; Debt Securities and Loans; Liability, Level (TCMDODNS)
https://fred.stlouisfed.org/series/TCMDODNS

NGDP: annual by default
Gross Domestic Product (GDPA)
https://fred.stlouisfed.org/series/GDPA

RGDP: annual by default
Real Gross Domestic Product (GDPCA)
https://fred.stlouisfed.org/series/GDPCA

Price Level: annual by default
Gross domestic product (implicit price deflator) (A191RD3A086NBEA)
https://fred.stlouisfed.org/series/A191RD3A086NBEA

Growth calculation: (A_t / A_t-20) - 1
where A is annual data from FRED, as specified.

References

Cecchetti, S., Mohanty, M. and Zampolli, F. (2011): “The real effects of debt”,  BIS Working Papers no. 352, September.
https://www.bis.org/publ/work352.pdf

Fasianos, A., Guevara, D., and Pierros, C. (2016): ‟Have We Been Here Before? Phases of Financialization within the 20th Century in the United States”, Levy Economics Institute working paper no. 869, June.
http://www.levyinstitute.org/pubs/wp_869.pdf

FRED  https://fred.stlouisfed.org/

Friedman, B. (1986): “Increasing Indebtedness and Financial Stability in the United States”,  NBER Working Papers, no 2072, November.
https://www.nber.org/system/files/working_papers/w2072/w2072.pdf

Goodfriend, M., King, R. (2005): ‟The incredible Volcker disinflation”. Journal of Monetary Economics 52 (2005) 981–1015.
https://www.bu.edu/econ/files/2011/01/GKcr2005.pdf

Investopedia (2021): ‟Financialization”.
https://www.investopedia.com/terms/f/financialization.asp

This paper online:
https://econcrit.blogspot.com/2021/10/debt-to-gdp-companion-graph.html